Authority to Borrow
Associations sometimes need to borrow money for special projects. These can include capital improvements such as building fences where none existed before or making repairs required where there are insufficient reserves to cover the cost. The authority for associations to borrow money is generally found in their governing documents (bylaws or CC&Rs). It can also be found in Corp. Code § 7140(i), which allows corporations to obtain bank loans subject to any limitations in the governing documents.
Collateral for Bank Loans
Directors should never personally guarantee loans made to the association--directors are volunteers and should not be putting their assets at risk for such loans. For bank loans to associations, banks require a different form of collateral. Most often, it's a special assessment approved by the membership that serves as collateral. (Civ. Code § 5735.) If, for some reason, the association defaults on the loan, the lender can step into the shoes of the association and pursue payment from the membership. If the bank requires a lien to be recorded against the common areas as security, it means the bank is unfamiliar with how associations work, and the board should contact other lenders.
Membership Approval
Check your documents before you apply for the loan. Membership approval of the special assessment (for capital improvement, repairing the common areas, etc.) may not be enough. The ballot may also require approval authorizing the board to enter into a loan agreement with a bank.
Loan Checklist
The following are issues that boards need to be aware of:
- Term. The term for bank loans is generally 3, 5, 7, 10, or 15 years, depending on the size of the loan.
- Credit Metrics. Before approving a loan, banks look at the association's (i) owner delinquencies, (ii) cash balances, (iii) percentage of renters, (iv) reserves, and other factors that may affect the stability of the association and its ability to repay the loan.
- Collateral for the Loan. Generally, a special assessment approved by the membership serves as collateral for the loan. Board members should never personally guarantee the loan.
- Application Fees. Some banks charge application fees; some do not. You should ask before you apply.
- Bank Deposits. Sometimes, banks require associations to move their operating and reserve funds to their bank as part of the loan approval terms.
- Financial Statements. Associations must provide financial statements and disclose delinquencies. If your association has high delinquencies and fails to comply with statutory requirements for annual financial statements, it is unlikely you will be approved for a loan.
- Good Standing. Associations must be in "good standing" with the Secretary of State before getting a loan. That means filing income tax returns and paying taxes. Boards can check their status online with the Secretary of State before initiating the application process.
- Insurance. Lenders sometimes ask about the association's insurance. Boards should check with the association's insurance broker to ensure their insurance meets or exceeds statutory and CC&R requirements.
- Authority. Boards will likely need authority in their documents to borrow or get approval from the membership.
- Attorney Opinion Letter. Banks usually require an opinion letter from the association's attorney as part of the loan approval process. Some require review by the lender's legal counsel rather than the association's. Boards should involve their HOA attorney from the outset to advise them about the approval process and to prepare the ballot for the membership if needed. Your attorney must provide an opinion about the association's authority to borrow.
- Prepayment Penalties. Will the loan have prepayment penalties? Avoid them if you can. The board may also need to set a policy regarding owners' prepayment upon the sale of their units.
Prepayment Issues
If prepayment is allowed without penalties, does it reduce the loan term or reamortize it? You want it to reamortize the loan so that loan payments are reduced. This issue will become important as units are sold. Frequently, buyers want the seller to pay off their portion of the special assessment so the buyer will not have to make payments.
Reamortize? Boards have discovered that prepayments create problems if the loan does not reamortize since the association must continue making the same loan payments to the bank but with less money from the membership for that purpose. This results in operational funds being diverted to the loan payments, which, in turn, results in higher assessments for everyone as the board is forced to increase dues to cover the shortfall.
Adopt Policies. To avoid this problem, boards can adopt a policy against member prepayments and require buyers to assume the seller's assessment payments. To adjust for this, buyers and sellers can negotiate arrangements between themselves, such as lowering the purchase price by the amount of the special assessment or leaving that amount on the table for buyers to use as they wish.
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